Popular funds sometimes have to stop accepting money

Frequently, the funds people most want to buy are the ones they can't have.

It's a phenomenon that is heating up in the fund world again because many of the top performers from one of the hottest sectors -- small-cap value -- are closing their doors to new investors.

About two dozen top-performing small-cap value and micro-cap funds have closed to new investors in the past year. That doesn't sound like much until you notice that the list includes many current winners.

It also represents a huge increase in the number of closed funds. About 300 funds have stopped taking money from new investors, according to Lipper Inc.

The latest funds to join the list -- or that soon will join it -- are N/I Numeric Investors Micro-Cap, which closed June 14; and Gabelli Small-Cap Growth (which is more value-oriented than its name implies) and the merger- oriented Gabelli ABC, both of which will stop taking new investments on Oct. 1.

As a general rule, closing a fund is a positive for investors who already own it. It also presents something of a danger sign.

It's good news because funds don't turn away money willy-nilly. In general, they stop taking new accounts because assets have grown to a point where managing more money could become a problem.

The motivation behind small-cap value closings is that bargains are hard to find right now, so managers are faced with either holding cash or migrating away from their typical stocks. That might mean buying more growth-oriented stocks or sliding toward mid-cap investments, moves that deviate from normal strategy.

Closings can portend bad news, however, because they represent a lagging indicator. By the time any investment category sees funds close regularly, the sector may be ready for a fall.

Several studies have shown that performance tends to slow after a fund closes, but the change has nothing to do with the fund's decision to turn away money and everything to do with the market.

That was borne out by technology funds in 1999 and 2000, when many took cover from the cash that was flooding in. Investors who beat deadlines and rushed to get in before the doors closed wound up being bludgeoned by the market for their effort.

"It's harder to invest within the sector at the kind of valuations we like to see," says Mario Gabelli of the Gabelli Funds. "That, plus not wanting to hold too much cash and not wanting to stray from our investment objectives is driving this move.

"Obviously, when a sector heats up and there are fewer bargains in it, the funds that invest in that sector are going to have a harder time."

For that reason, Gabelli does not expect his funds to see a rush of cash before they close. In the late 1990s, hot funds that announced a closing weeks before actually shuttering their doors would be deluged with cash, growing enormously just when managers wanted to stunt growth.

That kind of asset ballooning hurts existing shareholders, which is why most funds act like N/I Numeric and give little notice before closing.

Closings are not necessarily permanent. Just as a fund can turn off the cash spigot, it can reopen it when management feels there are new opportunities to pursue or when assets have shrunk.

Moreover, funds can put the lid on cash flow in different ways, from stopping absolutely everything including additional deposits from existing shareholders to simply shutting out new investors.

For example, Fidelity Magellan -- which in 1981 ended a 16-year closing that kept investors out for some of its best years -- currently is closed to new investors except for those offered the fund through a retirement plan. Existing shareholders can add to their positions.

That's a much softer cap than is used by, say, the Wasatch funds, which shut off both new and existing customers. The firm recently allowed investors who had previously established an automatic-purchase plan to restart their deposits, but even those investors cannot increase the amount that gets routed from their checking accounts to the fund each month.

In the end, because a closing is a pro-investor move, existing shareholders shouldn't fear it. If you're on the outside looking in, word of a closing may spur you to act hastily, which is a bit more dangerous.

Before diving in to beat the closing deadline, find out how tightly the lid will be on. Check the field to see if the competition is worth buying. If you can't get in or find a competitor, take solace in the fact that chasing hot funds looks good but can burn investors.